In the second quarter of this year, world trade and industrial production fell for the first time since the first quarter of 2009, while U.S. and European GDP growth came in well below expectations. At the same time, divisions over the U.S. debt ceiling and the euro rescue have convinced markets that policy cannot be relied upon for a cogent response. The result has been, not surprisingly, a stock market rout.
Are we headed for another global recession? We believe the answer is probably not, for three reasons. First, the powerful growth momentum in emerging markets appears likely to continue. Second, strong profit performance and balance sheets in the nonfinancial corporate sector in the advanced countries argue against a renewed sharp retrenchment so soon after a major downturn. Third, no “double dip” global recession has occurred since World War II, and it would take a truly massive shock to trigger one. The caveat is that precisely such a shock may be brewing in the form of a sovereign debt crisis in Italy and Spain, so containing the problem there is the single most important condition for a continued global recovery beyond its current soft patch.
Explaining the Slowdown
No smoking gun is responsible for the recent global slowdown. The vulnerability of advanced countries to shocks in the wake of the Great Recession, beginning with the sorry state of their public finances, is clearly part of the story. Large parts of the private sector are still struggling to regain their footing—the housing industry is chronically depressed, especially in the United States, and the health of European banks is highly suspect.1 Households in most advanced countries are cautious as they contend with large debts and the fear of unemployment. Such growth-dampening features are common in the wake of large financial crises and persist for many years.2
But two other features that predate the Great Recession are also responsible for the quagmire in advanced countries. First, Japan, the world’s third largest economy, is still—remarkably—suffering from the aftershocks of its own housing and stock market bubble more than twenty years after it exploded, and its government debt, which now stands at 233 percent of GDP, is rising very rapidly (its government deficit is just above 10 percent of GDP). Second, the eurozone is in the throes of a sovereign debt crisis, which is directly linked to its inadequately designed monetary union.
Against this background of acute vulnerability has come a cyclical and policy correction following the sharp global recovery between early 2009 and early 2011. Powered mainly by developing countries, global growth peaked at an unsustainable 5.9 percent annualized in the first quarter of 2010, and the resultant inflationary pressures and bottlenecks have forced monetary and fiscal policy corrections in developing countries. At the same time, advanced countries under fiscal pressure cut back their stimulus programs. Altogether, fiscal stimulus withdrawal is projected to reduce demand in the G20 countries by 1 percent in 2011.
To complete the picture, four very recent shocks contributed to the confidence crisis. In rough order of importance, these are: the spread of the euro crisis to Italy and Spain, whose combined government debts amount to $3.8 trillion; the Libyan mini-oil shock; the dramatic and sterile debt ceiling debate in the United States; and the Japanese earthquake.
Cumulatively, these factors—acute vulnerability, cyclical and policy corrections, and extraneous shocks—account for the recent cyclical slowdown. But are they enough to cause another global recession?
Sources of Strength
No accepted definition exists of a global recession. We define it here as a one-year decline in global per capita GDP at market exchange rates.3 Since the global population is currently growing at around 1 percent annually, this would imply world GDP growth of less than 1 percent at market exchange rates, compared to long-term potential global growth rate of around 3.5 percent a year. However, such an outcome, which would be consistent with sharply rising unemployment and falling commodity prices, is unlikely, for three major reasons.
There is little sign that the underlying drivers of growth in developing countries—technology adoption, urbanization, structural transformation, and investment—are about to slow. Indeed, despite the financial crisis, GDP in emerging markets has already surpassed its pre-crisis trend. Moreover, most of the large emerging markets are in strong fiscal and balance of payment positions to expand domestic demand in the event of a slowdown. Though they now account for only about 35 percent of world GDP at market exchange rates, in recent years, developing countries have accounted for about half of global growth.
We estimate the potential growth rate of developing countries to be just over 5 percent a year, which—given their current share of world output—translates into a 1.8 percent annual contribution to global GDP growth, technically sufficient to avoid a global recession even if advanced countries were to contract by 1 percent a year.
China alone has accounted for 22 percent of world growth since 2000, and a much higher share during the Great Recession. Despite inflationary pressures, its growth—driven by a supply-side transformation—is likely to remain resilient. Moreover, rising wages and employment are driving domestic demand growth, and China’s real exchange rate is appreciating, making its growth more autonomous than in the past.
Nonfinancial corporations in advanced countries are in good financial shape. They have cut costs and restructured (the other face of rising unemployment), reported strong earnings, and maintained strong balance sheets. In the United States, for example, nonfinancial corporations had their most profitable year ever in 2010, and the first quarter of 2011 was even stronger. Moreover, according to the Federal Reserve, U.S. nonfinancial corporations hold $1.9 trillion in cash and other liquid assets, the highest level on record. While firms remain cautious and investment is growing slowly, it is difficult to see why they would suddenly retrench in the absence of a large new shock.
No history of a global “double-dip”
Only four episodes of declining global per capita incomes have occurred since World War II: in 1975, following the first massive oil shock; in 1982, after U.S. monetary policy was tightened and interest rates reached well into the double digits; in 1991, in the midst of the U.S. savings and loan crisis and a big jump in oil prices in the wake of the first Gulf War; and in 2009, during the sub-prime collapse.
These episodes exhibit some common features. First, all were associated with a very major shock and none were the result of cyclical slowdown, such as we appear to be experiencing now. Second, reflecting the fact that imbalances that cause major recessions take time to build, they were widely spaced in time; there has been no “double dip” global recession in the post-war period (though there was in 1937, prolonging the Great Depression). Third, all were associated with U.S. recessions (the U.S. economy has slowed sharply but continues to grow and add jobs). Fourth, except for the first episode when developing countries still accounted for a relatively small share of global GDP, they occurred along with a very sharp growth slowdown in developing countries.
Europe is the Central Risk
There is a caveat to our assessment, however. Banks in sixteen European countries4 report a total exposure to Italy and Spain of $1.8 trillion, and an additional $900 billion exposure to Greece, Ireland, and Portugal. Moreover, banks in eight major non-European countries,5 including the United States and Japan, have $300 billion in direct exposure to the European periphery. Thus, were Italy and Spain to be cut off from international bond markets and unable to service their debts, the repercussions on the European banking system would be disastrous. In such a systemic crisis scenario, exposures to all European entities—not just to governments in the periphery—would matter. Banks in the eight large non-European countries have an additional $2.6 trillion in exposure to core eurozone countries, for example.
European Central Bank (ECB) liquidity injections and government bond purchases—and the creation of a large rescue fund that has, together with the IMF, engineered the bailout of Greece, Ireland, and Portugal—may be sufficient to contain the crisis in those smaller economies, but dealing with Italy and Spain represents an entirely different challenge in both scale and scope, arguably one that the core countries could not deal with without affecting their own credit standing, even if the political will for such action existed. ECB emergency purchases of Spanish and Italian debt appear to have stemmed the panic for now, but are not a long-term solution to these countries’ massive financing requirements.
The overriding priority for policymakers is to contain the euro crisis. As we have argued elsewhere, short of a catastrophic breakup of the currency union and debt defaults, the only durable solutions to the euro crisis are a combination of fiscal union (such as the issuance of jointly guaranteed euro bonds and the establishment of tougher jointly enforced fiscal disciplines) and far-reaching structural reforms in the periphery countries designed to reestablish growth and competitiveness.
In some advanced and emerging markets (such as Germany and China), some room exists for measures that sustain aggregate demand or delay stimulus withdrawal. In cases where inflation is a worry, more space would be created in the event of a global recession. In most advanced countries, however—beginning with the United States and Japan—there is little alternative to a program of medium-term fiscal consolidation coupled with modest (and relatively inexpensive) additional measures to relieve the plight of the long-term unemployed. While additional quantitative easing measures by central banks may provide a short-term boost to stock markets, their effect on sustaining aggregate demand at a time when liquidity is already plentiful is doubtful and their long-term implications (on inflation, carry trades, and speculation) unknown. Therefore, it is not minor changes in monetary or fiscal policies but the actions of European leaders that will be most important in preventing another global recession.
1. International Monetary Fund (IMF) Managing Director Christine Lagarde highlighted the weaknesses in European banks last weekend at Jackson Hole, saying they “need urgent recapitalization.